My Simple, Safe Investment Strategy for Playing Risky Stocks

There’s some hand-holding required out there in the stock market. We have seen destruction in the momentum biotech and Internet stocks that have corrected by more than 30%.

Now we are hearing some analysts on Wall Street saying to jump back in—but I’m hesitant at this juncture, as the downward risk is likely not over yet.

The reality is that, given the superlative gains recorded in 2013 by many of these biotech and technology momentum stocks, you shouldn’t be surprised to see the current malaise.

The fact that many of these highflying stocks in the stock market have more than doubled in a year should be a red flag. My simplest advice is to wait for the selling to subside in the stock market before you jump into these stocks.

You also need to be careful when hearing the bullish comments by Wall Street firms on these momentum stocks. Many of these firms have investment banking relationships with these stocks; it’s only natural to support your clients in the bad times.

Don’t get fooled by the stock market rhetoric. Instead, take a prudent approach to the stock market.

You don’t want to be caught exposed on this stock market unless you are fine with losing money should the selling intensify. Like I wrote at the beginning of the year, making money on the stock market will not be easy this year and capital preservation should be your objective.

Now, if you are willing to risk some capital and feel a stock market bottom is near, then what I suggest you do is consider using call options as a risk management investment strategy.

By employing call options, you can partake in a possible stock market bounce, while also controlling the amount of capital you have at risk, which is the premium paid for the option.

Let me show you how this simple strategy works using Tesla Motors, Inc. (NASDAQ/TSLA) as an example. (Note: this is only for illustration and is not meant to be an actual trade recommendation.)

Tesla has corrected 20% from its high. You feel it may be the right buying opportunity for this high-momentum stock and believe the stock could bounce up from the current $213.00 level to $250.00 by early May.

Chart courtesy of www.StockCharts.com

Under this assumption, you could buy the out-of-the-money $220.00 call on Tesla, priced at $8.40 per share, or $840.00 for one contract (which represents 100 shares of Tesla). This is your maximum risk.

Now, say Tesla surges to $250.00 by the May 9 expiry of the option. You would make $21.60 per share, or $2,160 per contract (=$250.00 – $220.00 – $8.40 x 100 shares), which would be a return on investment of 257% in a month.

Yet if the stock market reverses and Tesla falls to $180.00, you would lose the premium of $840.00 paid. If you had bought 100 shares of the stock, you would lose $3,300, which is much worse than the call option strategy.

Now the strategy may not work if the selling continues, but it will help to minimize the capital at risk, which is what you need to consider at this juncture.